The evolution of emerging markets over the past several decades has brought the asset class into the mainstream and into investor portfolios. And for good reason.
Emerging market equities now comprise over 10 per cent of the MSCI All Country World index, up from less than 5 per cent only 10 years ago and include some of the largest economies in the world.
Today’s emerging markets continue to offer investors exposure to some of the highest growth economies as well as a rich mix of investment opportunities, from small to mega-cap stocks, across all sectors of the market. Furthermore, valuations are, on average, relatively attractive versus historical levels and other asset classes.
The breadth of opportunity in EM is a reflection of the diversity of economic and corporate fundamentals that make up the asset class. EM equities offer exposure to 23 countries on four continents, some of the world’s biggest commodity exporters and importers, stable democracies and evolving political states, as well as global conglomerates and local entrepreneurs.
Performance of indices over 5yrs
Source: FE Analytics
The diversity of the emerging markets means that individual countries and companies may react quite differently even to common themes. For example, low oil prices are a blow to energy-exporting Russia’s already ailing economy, but a boon to importer India’s steadily improving one.
Furthermore, the rapid pace of development of many industries affords micro opportunities even when the macro environment is challenging. For instance, despite the negative effect of weak copper prices on Peru’s economy, we find Peruvian banks attractive because they face lower competition and have less leverage than banks in many other EM countries, which may enable them to earn above-average returns.
Similarly, although the near-term outlook for Russian consumers is weak, Russia’s fragmented food retail sector is in the process of formalising, which is creating opportunities for companies with good brands, competitive advantages and strong management teams to grow.
Therefore, sometimes our country weightings are in line with our view on economies, sometimes they are not. More importantly, we focus on investing in individual companies, rather than countries or macroeconomic themes, because we believe this strategy will generate sustainable alpha over the long term. Specifically, we look for sound businesses that we feel are priced at substantial discounts to their intrinsic value.
This stock-picking approach to emerging markets has led to some themes across our portfolios.
In most regions, we continue to have less exposure to state-owned enterprises (SOEs) because we are concerned about government influence, inefficiency and a generally poor allocation of capital.
This unfavourable view on SOEs, which account for 29 per cent of the MSCI Global Emerging Markets index, spares us more capital to add names outside of the benchmark. In fact, currently, almost half of the portfolio is invested in stocks that are not included in the benchmark, many of which are small and mid-cap companies.
One industry we like is stock exchanges, and we own shares in a number of countries. These capital-light companies have virtually 100 per cent conversion of earnings to cash flow, and attractive valuations with 4 to 7 per cent cash flow yields. They also tend to be monopolies and largely insulated from competitive pressures. By contrast, we struggle to find attractive opportunities in telecommunications because we believe the industry is very competitive and has high capital needs yet does not generate adequate returns on that capital.
Performance of indices over 3yrs
Source: FE Analytics
While India’s increasing growth rate is set to overtake China’s slowing one this year, equity market performance has been driven by a variety of underlying factors. Despite our overall more bullish view on India, we are selective in both markets, for different reasons.
India’s GDP is expected to grow roughly 8 per cent in 2015 and 2016, which is one of the highest growth rates worldwide. India’s reform-minded government, elected last year, is placing a big focus on improving the ease of doing business, which is a structural necessity for accelerating the economy and corporate capital spending, in our view.
Other initiatives emphasise investment in infrastructure and industrial projects, which should also help kick-start the capital spending cycle from the low point reached last year. In addition, as the fourth-largest user and importer of oil in the world, India is a huge beneficiary of lower oil prices, which are also helping tame the country’s high inflation rate.
Lower inflation has already allowed the central bank to begin cutting rates, in an effort to support economic growth. We believe businesses exposed to the domestic economy, such as industrial, consumer discretionary and financial companies have stronger prospects.
India had one of the best performing equity markets in the world last year but has given back some of the gains this year as macroeconomic tailwinds and government reforms have yet to show up in corporate earnings.
However, we believe that earnings growth in India could accelerate to around 18-20 per cent in the next few years, which is one of the fastest rates of any market and well above India’s long-term average of 14 per cent. In this context, current valuations, which are around the historical average, look reasonable, but we will look for opportunities to buy companies trading at discounts to their intrinsic value.
In contrast, Chinese equities have rallied sharply this year as the government continues easing measures in a bid to prop up economic growth.
However, the official GDP target is now below 7 per cent and several recent events could indicate further pressure on growth.
First, bottom-up signals such as power consumption, diesel consumption and the property market suggest lower growth than the official numbers. In addition, our conversations with banks suggest that the government’s efforts to stimulate lending may not be working. Lastly, the property market is still oversupplied and falling prices in most cities are dampening the urgency to buy.
We have limited exposure to banks and to SOEs in general, where we are sceptical of the profitability and the fundamentals are weak. As a result, we also have less exposure to the industrial economy. However, we are well-exposed to more entrepreneurial and consumer-oriented stocks in the staples, healthcare, IT and discretionary sectors.
Macro factors will influence economies, markets and even corporate behaviour in emerging markets. However, we believe that widening the range of investment opportunities, by considering off-benchmark and smaller-cap companies, and focusing on micro drivers of stocks, offer the greatest chance to generate sustainable alpha.
Katie Koch is global head of client portfolio management and business strategy for Goldman Sachs Asset Management. The views expressed above are her own and should not be taken as investment advice.